Partial Indexing Works For Wall Street, Not Investors

By Richard A. Ferri | January 04, 2010 AAA
Partial Indexing Works For Wall Street, Not Investors

You just received a call from your financial advisor. After a few pleasantries and a brief discussion about the weather, he lays this on you: "I've made a slight change to the way I manage investment portfolios. Rather than selecting mutual funds that try to beat the markets, I'm starting to use index funds." He continues: "But I'll only use index funds for efficient markets. In inefficient markets, I believe actively managed funds will provide superior investment performance."

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Welcome to "Core and Explore", also known by "Core and Satellite," "Barbell," "Core Plus" and a variety of other witty names. The theory suggests that index funds (or ETFs) work best in large and liquid markets and that actively managed funds work best in small and less liquid markets. Accordingly, a combination of index funds and active management generates higher returns than an all index fund portfolio. (For background reading, see A Guide To Core/Satellite Investing.)

I call the "Core and Explore" strategy "Core and Pay More" because you don't need active funds in any part of your portfolio. Truth be told, low-cost index funds are winners in all markets. The concept of using high-cost active management to explore so-called inefficient markets is a marketing gimmick that does nothing more then extract higher fees from an investor.

Charles Schwab (Nasdaq:SCHW) trademarked the phrase "Core and Explore" in 1998 during a period when S&P 500 index funds were clobbering a vast majority of actively managed mutual funds. Investors were voting with their feet by switching billions of dollars out of actively managed products and into low-cost index funds. Two large beneficiaries were the Vanguard 500 Fund and SPRD 500. By 1999, VFINX became the nation's largest mutual fund and reached over $100 billion in assets.

Schwab's Core and Explore strategy made active management appear profitable again, and that stemmed the outflow in at least some markets. All you needed to know was which markets were inefficient and which actively managed funds would outperform in those markets in the future. How do you know the answer to these questions? That is where expert advice comes in, or so the story goes.

Your advisor continues with his sales pitch: "Core and Explore will also save you money because index funds have lower expense ratios than active managers." And that is a true statement. The fees for low-cost market matching index funds and ETFs are lower than for actively managed funds by a wide margin. For less then 0.1% per year, you can invest in the entire U.S. stock market using the Vanguard U.S. Total Stock Market ETF or the Schwab U.S. Broad Market ETF.

At this point in the conversation with your advisor, you may be wondering why he has decided to switch to a core portfolio of index funds after spending years convincing you that this very strategy was flawed. You even recall one conversation when he called index funds "dangerous." What has changed?

What has likely changed is that your advisor has professionally matured to the point where he now sees that index funds are the best way to address client's needs. That is a good thing. However, this revelation creates a serious business problem--essentially the same problem that Schwab confronted in 1998. When an advisor becomes enlightened to the advantages of index funds, he or she also becomes concerned that clients will not stay because "who needs an advisor just to buy index funds?" Core and Explore is the interim answer. A Core and Explore advisor can continue to appear to add value in the selection of active managers on the explore side. That means he or she is worth keeping around.

Core and Explore would be fine advice if it worked, but it doesn't. The theory has several flaws. First, how does your advisor know which market is efficient and with is not, or if any market is efficient? The nation's top academics cannot even agree. Second, why should your advisor suddenly become more skilled in selecting managers in inefficient markets simply because he or she is no longer selecting active managers in efficient markets? Third, there is no unbiased academic evidence to support the notion that active managers outperform in any market.

Two often presumed inefficient markets are U.S. small-cap stocks and emerging markets stocks. According to Core and Explore theory, these are two markets where active managers should have excelled. That has not happened. Data gathered from the S&P Indices Versus Active Funds (SPIVA) Scorecard for the first half of 2009 shows that over 67% of small-cap core funds under performed the S&P 600 index over the trailing five years and about 90% of actively managed emerging markets funds underperformed the S&P/IFCI Emerging Markets Composite index over the same time.

There are no inefficient asset classes where high cost actively managed funds consistently outperform their appropriate benchmarks. This means Core and Explore is about paying for something you do not need and likely will not benefit from. If your advisor has progressed to the point where he concurs with an all index fund portfolio, then you have a good advisor. If he insists that he can select superior funds on the explore side, then perhaps you should do some exploring on your own--for a new advisor.

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